* Portugal, Italy lead fall in yields on first trading day of 2017
* Risk appetite boosted by upbeat PMI data
* European stocks hit one-year high
* German Bund yields touch eight-week low (Updates with move in Spanish yields)
By Dhara Ranasinghe
LONDON, Jan 2 (Reuters) - Borrowing costs in southern Europe fell to multi-week lows on Monday after strong manufacturing data and a rally in stock markets lifted appetite for lower-rated euro zone bonds.
Italy and Portugal were among the poorest performing bond markets in the euro zone last year, with annual yields rising for the first time since a 2011 debt crisis in the bloc on investor concerns over banks, fiscal policy and political stability.
But with data on Monday showing that factories in the region ramped up activity in December at the fastest pace in over five years, appetite for riskier assets received a lift.
Euro zone stocks climbed to their highest level in over a year, while southern Europe led a fall in government bond yields.
Portugal's 10-year government bond yield fell as much as 10 basis points to its lowest level for almost four weeks at 3.68 percent.
Italian and Spanish bond yields fell a similar amount to their lowest levels in about eight weeks at 1.72 percent and 1.31 percent respectively. Spanish bond yields were on track for their biggest daily drop since mid-December.
"You have new risk mandates and risk appetite tends to be stronger at the start of the year," said Nordea chief market strategist Jan Von Gerich.
"The PMI data for some of the peripherals was more significant than for the euro area as a whole -- In Italy it shows the recent political uncertainty is not reflected in the data."
Italian manufacturing activity grew in December at its quickest pace since June, the Markit/ADACI Purchasing Managers Index showed on Monday, signalling an acceleration in economic growth at the end of the year.
Most other euro zone bond yields were also lower, with safe-haven German bonds drawing some support after a New Year's Day gun attack in Istanbul that killed 39 people.
Germany's benchmark 10-year bond yield fell to an eight-week low around 0.16 percent, but trading was generally subdued with several markets closed for the New Year holiday.
Flash euro zone inflation data on Wednesday is shaping up as a key test of investor sentiment.
A bounce in oil prices and a reassessment of growth prospects after Donald Trump's White House win have boosted inflation expectations.
Euro zone market inflation expectations, measured by the five-year breakeven forward, are near their highest levels in more than a year.
Economists polled by Reuters forecast euro zone inflation to hit the 1 percent year-on-year level in December.
"That would mark a significant change in the overall inflation environment," said Commerzbank rates strategist Michael Leister.
"If the market's perception of the underlying picture changes, this brings forward the tapering debate significantly and that is the big risk we are looking out for."
The European Central Bank has not discussed ending its asset-purchase programme, ECB Executive Board Member Benoit Coeure told a German newspaper on Friday, though he said that would have to happen at some point.
Spain's Treasury said it would sell up to 4.75 billion euros of bonds at an auction on Thursday. (Editing by Richard Lough)